How to Stop the Banks' Bleeding: No Easy Choices

[one...two...tree 2,762]

By Stephen Gandel, Time

Timothy Geithner, you're on your own. If Geithner, who was confirmed as Treasury Secretary late Monday, plans on waiting until a consensus forms on what to do with the second half of the $700 billion bank rescue fund approved by Congress in early October, he may be waiting awhile. Economists, Wall Streeters and industry analysts are split on how best to spend what remains in the Troubled Asset Relief Program (TARP), which has done anything but offer relief.

Bank stocks have continued to plummet since the program was started in mid-October. Two of the nation's largest banks, Citigroup and Bank of America, have had to tap the relief fund twice, yet neither bank appears any more stable. Indeed, concerns about Bank of America's insolvency have grown, not shrunk, in the past few months. What's more, none of the government money spent so far has done anything to increase lending or lower foreclosures. (See the best business deals of 2008.)

"It's clear we need to do a lot more," says David Duffie, a finance professor at Stanford Graduate School of Business. "The losses at these banks are getting bigger and bigger."

But what to do? The only thing observers agree on is that none of the options are savory. Some economists believe we should stick with the current plan, and continue to buy up preferred shares in bank stocks. But a growing number of economists and industry watchers say we need a new direction. Among the ideas being floated are having the government take over the banks that are in the worst shape, creating a "bad" bank that would buy up the mortgage bonds and other assets, or changing accounting rules to protect banks from future loan losses.

What's clear is that Geithner, unlike his predecessor Henry Paulson, does not face a growing chorus of voices calling for a particular plan. Initially, Paulson was reportedly in favor of spending TARP money to buy up troubled assets. But shortly after the bank rescue fund passed Congress, a flood of economists came out against Paulson's plan. Instead, most policy experts advocated a plan to inject capital into the banks by buying preferred shares. The latter strategy would be quicker to implement and would do a better job of stimulating lending. Britain was instituting a similar plan, and it was already gaining praise. So Paulson balked, and by late October the capital-purchase plan was in place. The original TARP was dead in the water. (See the top 10 financial-crisis buzzwords.)

These days, however, few people think the capital-purchase plan makes sense. Paul Miller, an analyst at Friedman Billings Ramsey who covers bank stocks, says the problem with it is that the government is buying preferred shares and not common stock. Miller says preferred equity does nothing to help out common shareholders. That's because holders of preferred shares can demand their money back before holders of common stock can. As a result, bank stocks continue to plummet. And no matter how much total capital a bank or any firm has, if its stock goes to zero, it can't really operate.

That's why Miller argues that the government should start buying up common stock in the troubled banks, which would boost their stock prices, erase the perception of imminent failure and remove the likelihood that customers will run with their money. It may even boost lending. Of course, the problem with this is that some of these banks might need too much capital — and if the government buys all the common stock needed to fix the problem, it will own the banks, possibly a few times over. So a switch to buying common stock points to nationalization. (See pictures of the top 10 scared traders.)

Few economists like the idea of the government buying up banks and running them. Congress seems to have little taste for it as well. That's why the government came up with the preferred-share plan in the first place. The fear is that the government would do a worse job of running the banks than the current executives. What's more, once the government owns a bank, it has to pay for everything, from keeping the lights on to severance. And that could get very costly.

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Instead, a number of economists like the idea forming a bad bank to buy up assets tied to defaulting mortgage loans and other troubled debts. This is similar to Paulson's original idea for TARP. As those bonds fall in value, the banks have to take losses and write off capital, putting them closer to insolvency. If the government were to take the bonds off the banks' hands at their current price, that would stop the bleeding. Rod Dubitsky, who follows bonds backed by consumer loans at Credit Suisse First Boston, says buying up mortgage loans would greatly increase the capital of the banks. That's because the government purchases would probably push up the value of all bonds and improve the capital position of all banks, not just the ones lucky enough to offload their troubled assets onto the government.

The problem with this is, it's hard to know what to pay for the bonds. Pay too little and the banks will go out of business, because they will have to realize huge losses on the sales, wiping out their capital. Pay too much and the government ends up taking a big hit on worthless bonds. The one good thing with the preferred-share plan is that if the banks recover, taxpayers get their money back and the government might even see some upside in the shares. Not the case when you just buy the bonds. In that scenario, the banks improve, but the taxpayers take the full hit for the bad loans the banks made in years past. Few voters would likely enjoy that plan. So politicians are not going to be quick to embrace it.

Nouriel Roubini, the New York University economist who said early on that problems in the housing market could lead to a financial crisis, argues that both the bad-bank plan and the capital-repurchase plan need to be done at the same time. He suggests the government pay the low market price for the troubled bonds and then immediately inject capital into the banks. With the bad bonds off the bank's balance sheets, you would know exactly how much capital they needed to replace. What's more, the government would be buying shares in the banks at the low price, rather than shoving money in as they continue to go down. (See the top 10 financial collapses of 2008.)

The problem with this plan is that it would be very expensive, at least at first. Roubini estimates that U.S. banks need a total of $1.4 trillion in new investments to keep them afloat. Geithner probably doesn't want to be the person going to Congress to ask for that check.

Lastly, some people think the best solution would be to simply change the accounting rules. Congress would have to do it, but it might be an easy sell because it doesn't cost any money upfront. Many people argue that the that value of mortgage bonds, many of which plummeted in 2008, are reflective of a fear that many borrowers will not repay their home loans, not actual losses already taken. The nation's foreclosure rate, while up significantly, is still well under 5% for all mortgages.

So forget the rule that banks have to mark the bonds and other tradable loans on their books to market prices, which for the past year has been causing huge losses due the writedowns. Hedge-fund manager James Ellman of Seacliff Capital thinks removing the mark-to-market rule would give an immediate boost to the banks and to the economy as well. He predicts that shares of the banks would soar on the news, boosting the S&P 500 and repairing the damage done to millions of investors' 401(k) plans. It would probably help the positions of a number of investors like Ellman, who buys bank stocks, as well.

A number of accounting firms contend that allowing the banks to name their price for the assets on their books, rather than relying on the market, could undermine investor confidence in the banks. Who would trust a company that uses mark-to-make-believe accounting? Change the rule, they say, and banks stock could plummet anyway, just for a different reason.

There are the choices: nationalization; a bad bank; an accounting fix. Tim, for all of our sakes, please choose wisely.

http://www.time.com/time/business/article/...1873958,00.html

[alienlovechild 75]

This article is too long and too politically extreme to discuss.

[one...two...tree 2,762]

This article is too long and too politically extreme to discuss.

I agree...I wanted to edit it down, but didn't know where. Still, I think the three options for dealing with the banks was laid out pretty well. Unless you think there's a 4th or 5th alternative?

[alienlovechild 75]

I agree...I wanted to edit it down, but didn't know where. Still, I think the three options for dealing with the banks was laid out pretty well. Unless you think there's a 4th or 5th alternative?

Actually my comment was a joke aimed at those who didn't my thread by attacked it anyway as extremist.

I'm no banking expert and I'd piss on a spakplug if I thought it would help.

I'd let the most insolvent banks go under but back up remaining banks so they get the business from the failed banks and be a assured that there wouldn't a domino effect of collapsing banks. Nobody says it but clearly there are too many banks period. They make risky loans to drum up business.